The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market

by Pat Dorsey

Unless you know the business inside and out, you shouldn’t buy the stock.

This means that you need to develop an understanding of accounting so that you can decide for yourself what kind of financial shape a company is in.

Think of the time you spend on research as a cooling-off period.

As a result, the most profitable firms find themselves beset by competitors, which is why profits for most companies have a strong tendency over time to regress to the mean.

Economic moats allow a relatively small number of companies to retain above-average levels of profitability for many years, and these companies are often the most superior long-term investments.

The goal of any investor should be to buy stocks for less than they’re really worth.

We can compensate for this all-too-human tendency by buying stocks only when they’re trading for substantially less than our estimate of what they’re worth.

The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings.

The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.

To justify paying today’s price, you have to be plenty confident that the company’s outlook is better today than it was over the past 10 years.

As you can see, letting your money compound without paying Uncle Sam every year makes a huge difference, even ignoring brokerage fees.

You’ll find that it takes many great stock picks to make up for just a few big errors.

Loading up your portfolio with risky, all-or-nothing stocks—in other words, swinging for the fences on every pitch—is a sure route to investment disaster.

For one thing, the insidious math of investing means that making up large losses is a very difficult proposition—a stock that drops 50 percent needs to double just to break even.

In fact, small growth stocks are the worst-returning equity category over the long haul.

Moreover, many smaller firms never do anything but muddle along as small firms—assuming they don’t go belly up, which many do.

History does repeat itself, bubbles do burst, and not knowing market history is a major handicap.

You have to be a student of the market’s history to understand its future.

It seems entirely logical, but the reality is that great products do not necessarily translate into great profits.

Although great products and innovative technologies do matter when you’re assessing companies, neither matters nearly as much as economics.

When you look at a stock, ask yourself, “Is this an attractive business? Would I buy the whole company if I could?”

It’s very tempting to look for validation—or other people doing the same thing—when you’re investing, but history has shown repeatedly that assets are cheap when everyone else is avoiding them.

The asset classes that everyone hated

outperformed the ones that everyone loved in all but one rolling three-year period over the past dozen years.

You’ll do better as an investor if you think for yourself and seek out bargains in parts of the market that everyone else has forsaken, rather than buying the flavor of the month in the financial press.

That’s pretty powerful evidence that market timing is not a viable strategy because running a mutual fund is a very profitable business—if someone had figured out a way to reliably time the market, you can bet your life they’d have started a fund to do so.

The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for—not because you think a greater fool will pay more for the shares a few months down the road.

If the market’s expectations are low, there’s a much greater chance that the company you purchase will exceed them.

At the end of the day, cash flow is what matters, not earnings.

If operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rotten.

That’s the basic nature of any (reasonably) free market—capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

Five years is the absolute minimum time period for evaluation, and I’d strongly encourage you to go back 10 years if you can.

Although being in an attractive industry can certainly help, the strategy pursued at the company level is even more important.

The lesson here is that although firms can occasionally generate enormous excess profits—and enormous stock returns—by staying one step ahead of the technological curve, these profits are usually short-lived.

What matters is not the existence of the brand, but rather how the brand is used to create excess profits.

Therefore, unless the brand actually increases consumers’ willingness to pay and those looser wallets translate into consistently positive returns on capital, the brand may not be worth as much as you’d thought.

Think about an economic moat in two dimensions. There’s depth—how much money the firm can make—and there’s width—how long the firm can sustain above-average profits.

Companies record sales (or revenue) when a service or a good is provided to the buyer, regardless of when the buyer pays.

The cash flow statement, on the other hand, is concerned only with when cash is received and when it goes out the door.

Sales

영업으로 인해 유입된 현금거래 금액과 신용거래 금액의 합. 당기에 인식되는 현금흐름은 현금거래 금액과 상환된 신용거래 금액이며, 아직 상환되지 않은 신용거래는 나타나지 않는다.

Cost of goods sold

현금흐름표 상에선 전기에 이미 인식되어 있던 항목. 즉, 당기에는 이에 해당하는 현금을 차감하지 않아도 된다.

Depreciation

감가상각비는 장부상에서면 표현되며, 실제 현금이 즉시 지출되진 않는다.

This is the critical difference between accounting profits and cash profits—accounting profits match revenues (hot dogs sold) with expenses (a worn-out set of grilling tongs) as closely as possible, whereas cash profits measure only the actual dollar bills flowing into and out of a business.

If you look only at the income statement without checking to see how much cash a company is creating, you won’t be getting the whole story by a long shot.

(Remember, comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it’s owed by customers.)

Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken with a grain of salt.

More importantly, inventories soak up capital—cash that’s been converted into inventory sitting in a warehouse can’t be used for anything else.

Large companies that have a lot of leverage over their suppliers can push out some of their payables, which means they hold on to the cash longer—and that’s good for cash flow.

The only account worth looking at is retained earnings, which basically records the amount of capital a company has generated over its lifetime—minus dividends and stock buybacks, which represent funds that have already been returned to shareholders.

As you can see, the more differentiated a company’s products are, the more it can mark up its goods over what it costs to manufacture them.